Real Options and Mergers
P.V. Viswanath
Class Notes for FIN 648: Mergers and Acquisitions
Stock Options
 A call option on a stock is the right to buy a share of stock at
a pre-specified price (exercise price) within a specified time
period (time to maturity).
 Thus, a call on Sprint with an exercise price of $22.50 and
an expiration date of May 19, 2006 traded at a price of $2.15
at close on Feb. 22, 2006.
 The closing price of the stock on that day was $23.80, so if
the call had been exercised right away, it would have
resulted in a loss. Still the option has value because the stock
price might well go up before May 19, 2006.
P.V. Viswanath
2
Call option
Value of call
option at
option maturity
$5.00
$22.50
$27.50
Value of Sprint stock at option maturity
P.V. Viswanath
3
Real options
 A real option is similar to a stock option. The primary
difference is that the real option is not traded on a market
and, often,
 The underlying asset may not be traded on a market, either.
 Thus, a patent grants the owner an option because s/he has
the sole right for a certain amount of time (time to maturity)
to develop a product based on the patented idea by investing
the necessary capital (exercise price).
 The patent may or may not be traded;
 The underlying asset in this case, is the product based on the
patent. In this case, the underlying asset is not traded, either.
P.V. Viswanath
4
Importance of Real Options
 Real options are pervasive; for example, flexibility
usually implies a real option.
 Real options have a big effect on firm value where
the firm is growing and/or has unique assets.
 Real options capture effects that DCF doesn’t.
DCF analysis alone misestimates the value of an
asset.
P.V. Viswanath
5
Using real options in M&A
 Estimate the value of optionality.

The right to take action, the triggering of which is
contingent on some other event.
 Structure critical thinking about company values
and/or deal design.

Even if valuing the options is difficult, thinking of the
transaction in terms of real options can help qualitatively.
 Guide negotiation and problem-solving.

Helps in deal negotiation and in coming up with
solutions to impasses.
P.V. Viswanath
6
How to identify an option
 An option is a right regarding some other asset or good; can
you identify it?
 Options give the owner a special right that others do not
have. Is this right exclusive to you?
 The value of an option derives from the value of an uncertain
underlying asset. What is the contingency or uncertainty in
this case?
 Options are valuable, and are costly to acquire. Was the
right costly to acquire?
 An option has a finite life.
P.V. Viswanath
7
Options and opportunities
Option
The underlying asset can be identified
and is separate from the option
Whether you would exercise the right
before expiration is uncertain. The
sources of uncertainty are identifiable.
The value of the right is contingent.
Options are exclusive rights.
Resources are deployed to gain the
option
The life of the option is finite and
identifiable
Opportunity
The focus of the opportunity can be identified,
but is indistinguishable from the right.
The value of the opportunity is the value of the
underlying asset. Whether you will exploit the
opportunity depends on whether the NPV > 0.
Opportunities are not exclusive rights.
Opportunities are free.
Opportunities are often not time constrained
P.V. Viswanath
8
Example of option
 Right to start up a business under an exclusive fastfood franchise that you purchased, that expires
within three years unless you own one or more
outlets and that requires further spending to
exercise. You are the exclusive franchisee in your
territory. Whether and where you exercise the right
is contingent on the results of a market survey, on
zoning rulings by government, and on actions by
competitors.
 Needs to be valued using real option analysis.
P.V. Viswanath
9
Example of opportunity
 Opportunity to open a restaurant in your community
under a generic name, “Downtown Grille.” You
didn’t pay to acquire this opportunity. There is not
much uncertainty: you can rent the perfect location
that will deliver a steady clientele. It looks like a
good deal already.
 Can be valued using DCF analysis.
P.V. Viswanath
10
Decision Tree: Option to Delay
 You must decide whether to invest now in new
manufacturing capacity, for an outlay of $20
million, or wait a year. If you delay, you must
engage a contract manufacturer that will cost your
firm $1m. More to produce goods than if they were
produced at the new plant. Demand for the product
is uncertain. There is a 50-50 chance of the demand
generating a new business with either a present
value of $100 million or a present value of zero. If
you delay, the new plant will cost $25m. next year.
P.V. Viswanath
11
Decision Tree: Option to Delay
50% new demand is
permanent; build new
capacity
Wait to invest in
new capacity;
incremental cost
of outsource
manufacturing:
$1m.
Invest now in
new capacity;
cost: $20 m.
50% new demand is
permanent; do not build
new capacity
PV profits on new
demand: $100m. PV cost
of new capacity: $25m.
PV profits on new
demand: $0m.
PV profits on new
demand: $100m.
50% new demand is
permanent.
50% new demand is not
permanent.
P.V. Viswanath
PV profits on new
demand: $0m.
12
The Option to Delay: Deciding
 Value of Wait = -$1 + [0.5x($100-$25)]+(0.5x$0)
= $36.50
 Value of Invest = -$20 + (0.5x$100) + (0.5x$0)
= $30m.
 It pays to wait because of the high uncertainty
regarding the value of the underlying asset, i.e.new
demand.
 How to take time value of money into account.
 How to adjust for risk; riskiness of the option is not
the same as the riskiness of the underlying asset.
P.V. Viswanath
13
Option Valuation: Binomial Method
 http://webpage.pace.edu/pviswanath/class/648/note
s/options.htm#dcfvaluation
 http://webpage.pace.edu/pviswanath/class/648/note
s/options.htm#arbitrage
P.V. Viswanath
14
Option Valuation: Black-Scholes
 http://webpage.pace.edu/pviswanath/class/648/note
s/options.htm#blackscholes
P.V. Viswanath
15
Lucent: Assessing Latent Optionality
 Why is the actual market value different from
intrinsic value (break-up value of assets)?
 The reason might be real options.
 Shortly after Lucent was spun off from AT&T in
1996, the firm traded at $60, but assets-in-place
were worth $11.
 If the difference is due to a real option, what do the
option characteristics have to be?
P.V. Viswanath
16
Lucent: Assessing Latent Optionality
 Assumptions:





Current Value of underlying asset: $60
Life of option: 3 years
Exercise price: $15/share/yr. for the next 3 years (PV =
$34.24)
Project volatility: 75% per annum.
Risk-free rate of return = 3%
 Estimated Option Value = $38.70
 See spreadsheet from Blackboard: Class Documents
P.V. Viswanath
17
EM.TV
 In March 2000, EM.TV bought 50% of SLEC for €1.88b.
 At the same time, EM.TV also got a call to buy another 25%
of SLEC for €1.16b by Feb. 28, 2001 (in 4 quarters).
 Ecclestone got a put option to sell 25% of SLEC to EM.TV
for €1.16b by May 2001 (in 5 quarters).
 When the original acquisition was announced in March
2000, EM.TV fell by €2b.
 When news of the put option came out somewhat later,
EM.TV dropped in value by €2.2b.
 Is the market reaction due only to the put grant?
P.V. Viswanath
18
EM.TV
 Assumptions:




Value today of 25% of SLEC today is €0.97b.
Exercise price: €1.16b.
Volatility: 25% per yr; quarterly volatility is 0.25(1/5)0.5
Quarterly euro risk free rate is 0.985% per year.
 The sum of the values of the long call and short put works
out to -€0.138b.
 Modifying the initial values changes the values of the
options, but cannot explain the price changes.
 What amount of the price drop is due to a negative signal?
 Look at spreadsheet on Blackboard under Class Documents.
P.V. Viswanath
19
Binomial Method
 Grow the tree



Up value u = exp(t); down value = d = exp(-t)
PseudoProb{move = up}= [(1+rf)-d]/(u-d)
PseudoProb{move = down}= [u-(1+rf)]/(u-d)
 This achieves two things:


i) the volatility per period is exactly 
ii) the price in any period can be obtained by using the
pseudoprobabilities and discounting the values next period by the
riskfree rate.
 We have changed the probabilities in such a way that
discounting can now be done using the riskfree rate, instead
of the actual required rate of return.
 Since the option value is conditional on the true value, we
can value the option also similarly.
P.V. Viswanath
20
Value options on SLEC
 What is the value of the call that EM.TV got, and what is the
value of the put that EM.TV gave?
 We don't really have enough information here to estimate
these values precisely since along with the actual transfers of
money and options, there is also updating by the market on
the value of the other assets that EM.TV has
 However, we can evaluate certain hypotheses -- for example,
did the change in value reflect on the value of the options or
was there an information component, as well?
P.V. Viswanath
21
Valuing options on SLEC
 Suppose the original price that EM.TV paid for the
options and the 50% share of SLEC was fair, and
the entire reduction in the value of EM.TV.
 Then we can compute the value of the put option
and ask if the change in value at the later date was
due to the market’s reevaluation of EM.TV’s worth
in November 2001 or not.
P.V. Viswanath
22
MW Petroleum: Structuring the Deal
 In 1991, Amoco wanted to sell its subsidiary MW
Petroleum. Apache was the intended buyer.
 The initial asking price of $1 billion was beyond Apache’s
ability to finance.
 Even after negotiations, the gap between asking price and
offered price was more than 10% of the transaction value.
 Amoco, as the seller, was naturally more optimistic about
future pricing trends than Apache.
 How to structure the deal so that both parties would be
willing to proceed?
P.V. Viswanath
23
MW Petroleum: Structuring the Deal
 The two sides negotiated a price support agreement that
protected Apache on the downside in return for guaranteeing
Amoco a portion of the upside.
 Under the terms of this agreement, Apache would receive
support payments if oil prices fell below specified reference
prices for any year during the two-year period ended June
30, 1993, and Amoco would receive payments if oil prices
rose above specified reference prices for any year during the
eight-year period ending June 30, 1999, or in the event gas
prices exceeded specified reference prices for any year
during the five-year period ending June 30, 1996.
P.V. Viswanath
24
Some details of the price-sharing deal
 Oil price sharing payments due Amoco for contract years ending
6/30/1994 to 6/30/1999, would be based on per barrel oil prices
starting at $24.75 and increasing to $33.13.
 Annual oil volumes would decline from approx 3.3 million
barrels to 1.4 million barrels over the remaining term.
 Gas price sharing payments would be based on gas volumes
starting from approximately 13.4 Bcf for the year ending
6/30/1994, and declining to 10.5 Bcf in 1996.
 The referenced gas price would increase from $2.18 per Mcf in
1994 to $2.68 per Mcf in the final year.
 If price sharing payments are due to Amoco, the volumes listed
above would be doubled until Amoco recovers its net payments to
Apache ($5.8 million through the contract year ended June 30,
1993) plus interest.
P.V. Viswanath
25
Interpreting the deal
 Apache, which believes that oil prices are not likely to
increase will arrive at a lower estimate of the PV of the
payments to be made to Amoco; and at a higher estimate of
the PV of the payments that Amoco has to pay to Apache.
 Amoco’s estimates are the opposite.
 Hence, the price sharing agreements constitute a price
reduction for Apache and a price increase for Amoco.
 Alternatively, we could say that Amoco is selling Apache
price-protection – in case oil prices don’t stay high.
 Apache is able to pay for this insurance in the form of
“cheap” securities – an agreement to pay Amoco if oil prices
increase.
P.V. Viswanath
26